An Outline of the
American Economy

Part 1
Introduction

PART 5

Stocks, Commodities and Markets

The efficiency of the U.S. capital market is legendary. Historically, virtually every major city once had a stock market, but by the 1990s there were only three major markets: New York, New York; Chicago, Illinois; and San Francisco, California. Local markets persisted in such cities as Boston, Massachusetts, and Philadelphia, Pennsylvania, but trading was limited.

Capital markets in the United States have provided much of the money -- the lifeblood of capitalism -- to finance the building of thousands of factories and plants, research laboratories and office buildings, airplanes and ships. It is fair to say that if capital markets did not exist in the United States, they would have had to be invented. Although in recent years much capital has been raised through bond markets and in other ways, stock markets have often proved to be useful money-raising tools for new struggling companies.

Capital markets are said to be efficient when they can match quickly vast numbers of stocks put forth by sellers with vast demands for stocks put forth by buyers. In part, it is a matter of technology. The modern markets, particularly those in New York and Chicago, rely heavily on computerization each day to process millions of transactions. But also, in part, it is a matter of tradition and experience. The stock market works largely on one broker's trust in another broker's word. The brokers, in turn depend on the faith of the customers they represent. Occasionally this trust is abused. But during the last half century, the federal government has played an increasingly important role in insisting on clean dealing and unambiguous language.

This chapter is an attempt to explain how the stock market works. In large measure it is written from the standpoint of the small buyer and seller of stocks. But it is not hard to see how these small customers are able to interact to provide a quickly responding market.

The principles of this market are similar to all others. For every buyer there has to be a seller. When more people wish to buy than to sell, the price tends to rise; when fewer people wish to buy and many wish to sell, the price tends to fall.

So broad is the ownership of stock shares that owners can easily follow the fortunes of the market on a daily or even hourly basis. Investors get their information in a variety of ways. If they are willing to wait until the markets close, they can simply look at the markets pages of large daily newspapers to find out what happened in the previous trading session. There are a variety of indexes that measure market activity broadly, and individual stocks are also listed, showing the number of shares traded, the closing price, and high and low prices reached during the trading session. Certain television programs devoted to business report immediate developments in market movements. For those who insist on getting up-to-the-minute information about price movements of individual stocks, computerized services will deliver this information almost instantaneously to their homes over telephone lines.

Also, investors often subscribe to magazines and newsletters devoted to analyzing movements in individual stocks and the markets in general, and speculating about the future.

Once a company has sold its original stock to the public and it is traded freely in the market, the price will be determined continuously during the trading day by what buyers will pay and what sellers will take. It is simply a matter of supply and demand. Thus, the price is the composite opinion of all the people who buy and sell that stock. Factors that influence how much people will pay include:

• The general business climate or trend, depending on the state of the overall national economy, and the amount of confidence the public has in it;
• The amount of profit the company that issued the stock has been making, or is predicted to make, and its financial condition;
• The rate at which the company is growing or declining;
• The ability of a company to compete successfully with its rivals over a period of time;
• Whether the product or service is one that is popular, and whether the market for that product or service is growing or decreasing;
• The general interest rate, or the market price for bonds;
• The rate of return the company offers compared to the rate of return on alternative investments.

THE IMPORTANCE OF DIVIDENDS

As previously noted in a different context, when a company makes money it usually pays a part of its earnings to its shareholders in the form of dividends. A typical payout is about 50 percent of the earnings. Thus, if a company made $20 million in a year and if there were 5 million shares of stock, this company might declare dividends in the amount of $10 million, retaining the other half for immediate operations and/or expansion. So if there were 5 million shares of stock in the company, each shareowner would receive $2 per share. If one owned 100 shares, the dividend would be $200. To carry the arithmetic a step further, if a stock sold at $40 per share and yielded a $2 dividend, the rate of return per share would be 5 percent.

THE ANNUAL REPORT

Each year every stockholder receives an annual report about the company in which he or she has an investment. These annual reports have changed much over the last 20 or 30 years. Previously, the typical report would consist of a general discussion of the health of the company, without any comparisons to previous years. Now virtually all major corporations give very detailed reports. They provide easy-to-read charts and summaries, usually covering a 10-year period. A certified public accounting firm, after performing an audit, certifies that the figures and statements about the finances reflect generally accepted accounting principles. In addition to this information, company executives are required to disclose the extent of their holdings in the company. The entire process is supervised in great detail by the Securities and Exchange Commission (SEC), often described as a "watchdog" agency of the federal government.

THE STOCK EXCHANGES

While there are literally thousands of stocks, the ones bought and sold most actively are usually listed on the New York Stock Exchange (NYSE). The exchange dates back to 1792 when a group of stockbrokers gathered under a buttonwood tree on Wall Street in New York City to make some rules about how buying and selling was to be done. The NYSE has become the leading exchange in the United States, but the American Stock Exchange also operates in the same Wall Street area, and in much the same way, but on a smaller scale.

The NYSE, housed in a large building on Wall Street, does the bulk of trading in listed securities. On the trading floor more than 2,200 common and preferred stocks are traded. The NYSE has some 1,600 members, most of whom represent brokerage houses involved in buying and selling for the public. They buy "seats" on the exchange at considerable expense. They are paid commissions by the buyers and sellers who execute their orders. Almost half a million kilometers of telephone and telegraph wire link the NYSE with brokerage offices around the nation and across the globe.

Direct stockholders in American business number approximately 42 million. In addition, there are over 133 million indirect stockholders who share in the ownership of American corporations through their contributions or participation in pension funds (public and private), insurance companies, mutual funds, banks, foundations, colleges and universities.

How are stocks bought and sold? Suppose a schoolteacher in California wants to go on an ocean cruise. To finance the trip she decides to sell 100 shares of her General Motors stock. The schoolteacher calls her stockbroker and directs him or her to sell the shares at once at the best price. The same day an engineer in Florida decides to use the savings he has accumulated to buy 100 shares of General Motors stock. The engineer calls his broker and puts in a buy order for 100 shares at the market price.

Both brokers wire their orders to the floor of the New York Stock Exchange. The two brokers, one representing the widow and the other the engineer, negotiate the transaction. One asks, "How much do I have to pay for a hundred shares of General Motors?" The highest bid is $50.00 and the least amount for which anyone has offered to sell is $52.00. Both want to get the best price, so they compromise and agree on a buy/sell at $51.00.

The NYSE itself neither buys nor sells stocks; it simply serves as a mechanism by which brokers buy and sell for their clients. Each transaction is carried out in public and the information is sent electronically to every brokerage office in the nation.

OVER-THE-COUNTER STOCKS

The largest security market in the world in terms of the number of different stocks and bonds traded is the over-the-counter (OTC) market. OTC is not located in any one place, but is primarily an electronic communications network of stock and bond dealers. These stocks are supervised by the National Association of Securities Dealers, Inc., which has the power to expel companies or dealers determined to be dishonest or insolvent. The over-the-counter market tends to get stocks of smaller companies, and by the 1990s had come to be known as a market where many of the fastest growing "high-technology" stocks could be bought and sold. Again, information about trading activity can be acquired through newspapers, magazines, or electronically. A brokerage house usually handles purchases and sales of these stocks along with those on the major exchanges.

Many persons who do not feel qualified to decide which stocks to purchase, but who nevertheless want to participate in the stock market in hopes of making a profit by doing so, turn to mutual funds. A mutual fund combines funds of its shareholders, which may be in small amounts, and invests large blocks of money in a varied portfolio of stocks, thus reducing the risk, which is another reason why many people prefer this method of investing in stocks.

Another advantage of mutual funds to the customer is that the fund's managers get professional advice from staff analysts. It is possible for a fund to employ such persons because the operation is on a large scale. There are dozens of kinds of mutual funds. Some are designed for income, some for capital appreciation, and others are speculative with the chance for large gains or severe losses. Some deal only with stocks of specific industries, or stocks of foreign companies, or companies whose activities benefit the environment. The number and variety of funds proliferated greatly in the 1980s; the total number of funds lumped from 524 to 2,918 over the decade, while the portion of U.S. households holding shares in mutual funds increased from 6 percent in 1979 to 25 percent in 1989.

BUYING STOCK ON MARGIN

Americans buy many things on credit, and stocks are no exception. Investors who qualify can make a stock purchase by paying 50 percent down and getting a loan for the remainder. This is called buying on a "margin" of 50 percent. The balance is borrowed at interest from the brokerage house and the stock certificates are deposited with the broker as security. The Federal Reserve Board regulates the minimum margins, the amount that must be paid in cash as a percentage of a purchase. The minimum margins vary, depending on whether there is need to stimulate the market or curb its speculative enthusiasm.

If an investor sells stock held on margin that has appreciated, the investor may pocket the profit and pay the broker the amount that was borrowed plus interest and commission. If the stock goes down, the broker can issue a "margin call," and the investor is required to pay an additional amount into the account. If the owner cannot produce cash, some of the stock is sold at the investor's loss.

Buying stock on margin gives speculators (traders willing to gamble on high-risk situations) the opportunity to extend the scope of their operations. Their available cash will buy many more shares, giving them the opportunity of making more profit and also the risk of suffering greater losses.

At times the Federal Reserve Board requires a 100-percent margin, meaning that all stock must be paid for in cash. During the 1950s, for example, the margin rate varied from a low of 50 percent to a high of 90 percent. A low rate, of course, stimulates stock buying, while a high rate discourages it.

The first concern of most investors is the safety of their purchases. If necessary they will often take lower dividends to avoid great risk. In contrast, speculators hope to see the price of their stocks go up, usually within months, or even days. They are more interested in the future of the stock than in its earning power at the time of purchase. People who believe they can outguess the market try to buy before prices rise and sell before they fall.

There is also a group of speculators known as "short sellers." A short seller is someone who invests money because he or she expects a particular stock to go down in value. This person sells "borrowed" stock, in hope of replacing it later with stock bought on the open market at a lower price. This is one of the riskiest ways of investing in the market, because the price of a stock that is doing very well may rise tenfold or more, in which case the "short" gets "squeezed" for a big loss. Selling short is governed by specific rules to prevent abuses of a type that occurred in an earlier era on Wall Street.

COMMODITIES FUTURES

The prices of commodities -- such as crops, livestock and such metals as copper, gold, lead and tin -- tend to fluctuate from one period of time to the next. Commodity traders fall into two broad categories: hedgers and speculators. Hedgers are business firms (or individuals) that enter into a commodity contract to be assured access to the commodity at a guaranteed price. A firm secures a needed commodity and is protected against price fluctuation. Thousands of individuals, in contrast, trade in commodity futures as speculators.

The major reason for the rising volume of commodity speculation is the lure of huge profits which can be made on small or thin margins. Uncontrolled forces such as weather or wars can affect supply and demand and send commodity prices up or down very rapidly, thereby creating great profits or losses.

Speculating in commodities is done primarily at a commodities exchange, and there are a dozen such exchanges in the United States. These exchanges are voluntary trade associations, but they are called organized markets because members are required to follow set trading rules. Some of the most prominent are in Chicago, which is the historic center of America's agriculture-based industries. The Chicago Board of Trade is the largest center in the world for commodity futures in terms of volume and value of business. Another Chicago-based exchange is the Chicago Mercantile Exchange, which originally traded mainly in farm products, but has branched out to trade in foreign currency futures.

How does the commodity-trading system operate? Suppose a person bought a standard contract for 30,000 kilograms of cocoa. This buyer could pay the money and take possession of the cocoa. Or the buyer could make the purchase and then sell the contract to someone else. Most people have no need for that much cocoa, nor do they have a place to store it. Their purchase is purely a paper transaction; they hold the contract with the intention of selling it to someone else.

Commodity futures contracts, like stocks, are traded on margin. The difference typically is that a commodities margin is only about 10 to 20 percent of the value of the contract, which increases the opportunity for speculation, and large gains or losses.

Those who make money are often professional traders, well versed in the way the market is likely to react. It has been estimated that of all the small buyers who enter this market, 85 percent lose money. In practice this statistic suggests a few very large winners and a great many losers. The risks are high because a small price change raises profits or losses dramatically.

MARKET DYNAMICS

Markets in stocks and commodities form a vital part of the American economic system. Millions of individuals buy and sell small lots of stocks and commodities while mutual funds and trusts trade in large lots. In good times, when it appears that prices will rise, money from savings or from other types of investment flows into the market. When this happens, prices are driven higher. Often a period of speculation follows in which the "bulls," those who make money on a rising market, dominate the market. When the market can no longer sustain the speculative fever, a reaction sets in, selling develops and prices begin to fall. At this point the "bears," or those who make money in a falling market, are the gainers.

During this process the Federal Reserve Board may be trying to curb excesses and stimulate or dampen the market by raising or lowering the margin. The flurry of buying and selling also creates a temptation for some "insiders" (those with access to special information) to try and manipulate the market in a given stock. While this illegal activity was once commonplace, it happens much less frequently now, owing to active policing by the SEC.

A new factor of significance in the market is the volume of funds from abroad that is being invested. Not only has Middle Eastern oil money made its way into American securities, but many people in Europe, Japan and other parts of the world feel that their best opportunity for securing their wealth is to invest in American stocks. This preference for investment in the U.S. economy partially explains the extraordinary strength of the American dollar in the early 1980s. It also, of course, is partly responsible for the gradual upward climb of stock prices in the decades toward the end of the century.

THE SECURITIES AND EXCHANGE COMMISSION

The Securities Act of 1933 and the Securities Exchange Act of 1934 were designed to help protect investors, not only from fraud but also from the problems of misunderstandings associated with inadequate or unusual data-reporting. Enacted during the Great Depression (1929-1940), these laws and others passed in subsequent years are administered by the federal Securities and Exchange Commission (SEC). Before the SEC was created in 1934, securities were regulated by the individual states. Federal laws were created to supplement, rather than to replace, what were often inadequate state laws.

The SEC has five commissioners who are appointed by the president. No more than three commissioners can be members of the same political party; the five-year term of one of the commissioners expires each year.

Companies issuing stocks, bonds and other securities to the public must file a detailed financial registration statement with the SEC, and the SEC determines whether the registration statement is complete and accurate. This ensures that buyers can make an informed and realistic evaluation of the worth of available securities. The SEC oversees trading in stocks after their distribution as well, administering regulations designed to prevent manipulation of the price of a stock traded on the market. Brokers, dealers in the over-the-counter market, and even the stock exchanges themselves must register with the SEC.

The SEC regulates interstate market securities and enforces laws against unfair and illegal practices. It also requires companies to provide information for the public about how many shares of their stock are being bought or sold by officers of the company. The SEC believes that, because these persons have privileged information about the company, which makes them "insiders," their buying or selling can indicate to other investors their degree of confidence in the future of the company. The laws have had some success in preventing fraud and secret dealings aimed at manipulating stock prices.

In its recent history the SEC has taken on the responsibility of overseeing corporate policies, particularly by requiring reports designed to uncover illegal company payments to political figures or others for the purpose of buying their influence. What may be common business practice in many countries is in some cases unlawful in America. Congress has charged the SEC with seeing that American corporations abide by American business ethics even when doing business in another country. The SEC is a good example of an agency created to protect the American public through the regulation of business enterprise.

"BLACK MONDAY"

On Monday October 19, 1987, the value of stocks plummeted on markets around the world, with the Dow-Jones Industrial Average (the main index measuring market activity in the United States) failing 508.32 points to close at 1738.42. The 22-percent fall was the largest one-day decline to have occurred since 1914. A presidential commission was appointed to investigate the causes of the crash and both the commission and the SEC issued reports.

In part, investors' concern about the U.S. federal budget and international trade deficits were found to be responsible. Comments made by the U.S. secretary of the treasury, who criticized foreign economic policies and hinted that the Reagan administration would let the U.S. dollar's value decline further against other currencies, may also have contributed. But, in the view of many analysts and the presidential commission, the key factor was program trading, a recent development on Wall Street in which computers are programmed to order the buying or selling automatically of a large volume of shares when certain circumstances occur.

The commission, named the Presidential Task Force on Market Mechanisms, but known as the Brady Commission, also criticized "specialists" on the floor of the New York Stock Exchange. These money makers, the commission said, neglected their duty by not becoming buyers of last resort and by treating small investors "capriciously." The SEC joined in faulting computerized trading and exchange specialists as well as citing a negative turn in investor psychology. Both the Brady Commission and the SEC called for greater regulation.

On February 4, 1988, the New York Stock Exchange established safeguards which forbid the use of its electronic order system for program trading whenever the Dow-Jones Industrial Average increases or drops 50 points in a single day.

Meantime, the stock market recovered and began another upward climb, with the Dow-Jones Industrial Average topping 3000 in the early 1990s. But stock markets can be highly volatile, and wide fluctuations are expected to continue over time.

An Outline of the American Economy